Options and Their Underlying Asset

Good Morning!

This is the Jumping Cholla (CHOY-uh). The newsletter that turns options market insights into a fun, easy-to-read email that helps you reduce your chances of getting pricked while trading!

Quote of the day:

"The most important thing in understanding any problem is to understand the underlying principle"

If Henry Ford didn't understand the core principles of a car, there was no way he'd get Chitty Chitty Bang Bang to fly!

Building an intuition for option positioning, pricing, time value, etc. all starts at "first principles", and definitely not while YOLOing 10 delta calls during the pandemic!

The most fundamental relationship in option derivatives trading is Put-Call Parity. FYI, it's called a derivative for a reason, and it's not just finance turds trying to sound smaht!

BANG for Your Buck:

Yesterday's Price and Volatility Recap

Volatility increased even with a "smaller than BANG" trading range. What does that tell us?

Supply/demand for options led the feedback loop (look at the diagram at the bottom). People net buying options implies that there must be a higher-than-expected underlying move upcoming. This doesn't tell us direction, or that people en masse are actually right. But whatever they believe, they put their money where their mouth is and the option bookmakers "adjusted their lines" accordingly! Maybe this demand was led by people hedging?

Well, what's happening today?

That stuff in green, like CPI, core CPI, year over year CPI, etc., is kind of a big deal (and that's only because the professional pontificators tell you so!)

When the unknown becomes known (i.e. after the numbers are reported), that warm and fuzzy extrinsic value feeling loses its luster (volatility decreases).

So, be on the lookout for a decent move, and unless the move is bigger than BANG, look for a decrease is volatility.

Put-Call Parity

An option is called a derivative because its value is derived from, or is dependent upon, the value of an underlying asset. The value of the option changes, in part, based on changes in the underlying asset's price.

In the world of bona fide hedging and not just financial speculation, some people actually exercise their options at the strike price to receive the underlying asset itself (what a novel concept?!).

Let's get some basic definitions out of the way:

• Underlying asset's price (we usually just call it the "underlying") = the current price of the underlying asset

• Exercise = Buy or sell the underlying asset at the given strike price

• Strike Price = The price at which the underlying asset will be purchased or sold at

• Call = A contract between a buyer and a seller that gives the buyer the right, but not the obligation, to purchase the underlying asset at the predetermined price (strike price)

• Put = A contract between a buyer and a seller that gives the buyer the right, but not the obligation, to sell the underlying asset at the predetermined price (strike price)

Example

The Coca-Cola Corporation might buy a Corn Call option with a strike price of $7 so they can lock in that "$7 per bushel is the maximum price they will pay for corn".

If corn's asset price goes to $7.50 per bushel, they can exercise their call option at the $7 strike price and only pay $7 per bushel, thereby saving 50 cents. (They then turn that corn into sweet, sweet nectar and sell to your phat @ss at an even better profit margin!) If corn only makes it to $6.75, they do not exercise the call and instead buy the Corn at the current and cheaper price of $6.75. Makes sense right, it's like an insurance policy for corn!

Now instead of a call, let's think about a Put.

You ever get stuck at train tracks and see containers upon containers with ADM stamped on the side...yeah that's one of the largest sellers of corn in the world.

Let's say ADM wants to make sure they can sell their corn for $7 per bushel at the very least. So, they buy a Corn Put with a strike price of $7. If corn's asset price goes to $6.75, they can exercise their put option the $7 strike price and sell their corn for $7 per bushel, thereby making 25 cents more than the current price. Anything over $7, they'll just sell at the higher price and not exercise the put.

Well, that's the option seller's dream!! There is no value in exercising the call or the put! (although, pinning in the world of physical settlements has tricky consequences; therefore, people still do in order further tinker with the market)

Let's go back to remedial math and write the equation for these word problems:

Whoa! Let's assume you always know the strike because that never changes for a given option. So, by knowing 2 out of 3: asset price, call price, and put price, you also know the 3rd one.

• knowing the call and put price for a strike implies the asset price.

• knowing the call price and the asset price implies the put price

• knowing the put price and the asset price implies the call price.

We are just dipping our toes in. If this one didn't click, don't worry, we'll be explaining put-call parity in a multitude of different ways all year...We still need to decipher intrinsic vs extrinsic value and incorporate interest rates!

As always, pursue the process NOT the profits! See you tomorrow!